Beware of the Bull

In what would have been a spectacular week under other circumstances, the Dow Jones Industrial Average (DJIA) gained nearly 13%. The S&P 500 Index (SPX) was up more than 10% and the NASDAQ Composite Index (COMP) rose a little more than 9%. The cable business channels gushed lovingly about the rally. “DJIA Having Best Week Since 1930s.” “S&P Having Best Week Since 2008.” And, at one point on Thursday, after DJIA had climbed more than 20% from Monday morning’s low, they declared, “Dow Enters Bull Market.” Even the “Wall Street Journal,” following Thursday’s big gain, proclaimed, “The jump ends an 11-trading day bear market for the index—the shortest in history for the Dow—which reached its bear-market low three days ago.”

I urge you to be cautious of declarations of this type that are based on semantics alone. As the reporting of market activity has become more mainstream, it created a need to be able to slap labels on certain market events for the sake of convenience. So, to be able to officially declare a “Bear Market” based on an arbitrary 20% decline gave the reporting an air of authority and substance. And, to not start counting the length of a bear market until after the averages have declined by 20% seems like cheating. Just as it’s silly to imply that there’s nothing to worry about until the averages have declined by more than 20%, it is likewise irresponsible to declare an “all clear” based on a 20% bounce and imply that downside risk has magically vanished.

Last week’s rally was certainly a welcome change following weeks of steep losses, but it wasn’t unexpected, and it really hasn’t changed the prevailing market sentiment, other than semantically. As I wrote last week, all the important preconditions for a good short-term low were in place. And, that whenever a rebound rally might get going, it should be able to recover a big chunk of the lost ground in a hurry. That rebound rally began last Monday, and as expected, it recovered a sizeable slice of the recent losses quickly. Repeat after me, “The most impressive short-term rallies occur as rebounds in continuing downtrends.” The market is rallying through the vacuum left by the preceding whoosh down, and the averages need to rally enough to convince a significant percentage of market participants that a new bull market has begun.

With all that as a background, there are likely three key questions on the minds of investors:

So, how much further should we expect the rebound to carry? My first target for the rally is the 2640 – 2660 area of SPX. That level represents both a typical retracement percentage and SPX’s 200-week moving average. Last Thursday’s high was just at the bottom edge of that range. Sustained trading above that level would introduce the 2800 area as the next target. Getting back to that level would constitute a 50% recovery of the recent loss. While it’s unlikely that SPX can rebound beyond that range, doing so would establish a new target range in the high-2900s.

What can we watch for as signs that a new leg lower has begun? If, in fact, the averages can continue to stair-step higher for another week or two, watch the most recent pull-back low as a danger level. A lower low with follow-through might not only be a signal to head for the hills, but also could be followed by another air-pocket decline as traders far and wide would respond to the deterioration. (See last week’s comments regarding a sleeping cat and a cherry bomb.)

What should I do over the coming weeks? The answer to that question depends so much on an individual’s personal situation and investment objectives, that speaking with an investment advisor would be a valuable component in determining the appropriate answer. Generally,, the worse you felt two weeks ago and the more the market rebounds, then the more you should look for ways to reduce exposure. Folks with a little cash on the sidelines should probably wait for a better buying opportunity. Folks with a lot of cash on the sidelines could do a little bargain hunting, but I would encourage them to spread it out, both in time (i.e. a series of partial purchases at two or three-week intervals) and among several buy candidates.

Even the recently underperforming Russell 2000 Index of small-cap stocks (RUT) had a very good week, nearly matching DJIA’s gain. I suspect the relatively strong performance was more the result of the thinness of the small-cap market than the fundamental strength of RUT’s component stocks. A large percentage of RUT’s component companies are carrying high levels of debt, are not cash-flow positive, and/or are not profitable. Going forward, I expect investors will seek out stocks of companies with strong balance sheets and strong, positive cash-flows.

With the recent liquidity squeeze in the credit markets and the high probability that most companies will see significant declines in revenue in the coming months, highly leveraged companies could get into trouble quickly. Investors are likely to favor companies with low debt-to-equity ratios, a history of strong free cash-flow and plenty of cash on hand. Investors are likely to avoid companies that experienced years of negative cash flow, negative earnings and increased debt during the recent years of healthy economic activity.

Companies, especially smaller companies, in the Energy sector are a case in point. For obvious reasons, increased supply and decreased demand, the price of Crude Oil remains under pressure. Last week, Crude dropped another 5% to $21.51 per barrel. It seems unlikely that either Russia or Saudi Arabia will relent and cut production anytime soon. Several small, highly leveraged domestic producers are likely to not survive the year.

Along with airline and hotel stocks, cruise ship companies were easy and obvious first targets of the covid-19 attack. Cruise line stocks sank by as much as 80% from their January highs to their March lows. Early last week, a little of their buoyancy was restored when talks on Federal relief for certain industries gained momentum. But all the air went out of that bubble when someone noticed that the cruise lines are predominantly foreign companies, which have paid no tax in the U.S., and therefor would be ineligible for aid.

One of the studies I update on a regular basis is a comparison and ranking of a widely diverse group of funds and asset classes. To create a score for each fund, I compare the performance of each component to that list of each of the other components over several different timeframes. In what is an extreme rarity, the U.S. Dollar and Cash are now at the top of that performance ranking. That’s probably not a surprise considering that EVERYTHING else has been selling off. The real eye-opener for me was to see the concentration of funds representing innovative, disruptive technologies very near the top of the list.

If there’s a silver lining in the covid-19 cloud, it may be that times of crisis tend to accelerate the adoption of new technologies. How many families who were not planning to subscribe to streaming services or to shop online or to have groceries or meals delivered or to make virtual payments on their cell phones, will adopt one or more of those services in the months ahead? Many firms offering these technologies are relatively young companies; the one’s that can survive the economic downturn could see a big increase in their customer bases.

One factor that could have a significant impact on the stock market, good or bad, in the weeks ahead is the health of the credit markets. A week or two ago, those markets were in shambles, worsening the panic selling in stocks. Junk bonds, munis, direct loans, mortgages were all trading at fire-sale prices. The Fed’s huge liquidity injections helped to restore order, and, in part, that helped stocks rally last week. But late in the session on Friday, news that the Fed was reducing the size of its purchases triggered a steep sell-off in stocks in the final half-hour. The degree to which the credit markets hold together, as well as the speed and size of the Fed’s response if they don’t, could be important short-term catalysts.

Last week brought the first ugly economic date with Thursday’s Initial Jobless Claims report. This week’s calendar is lighter, but probably uglier. Additional reports will cover weeks and months impacted by the contagion’s economic damage. Economists expect Friday’s Non-Farm Payrolls report to show a reduction of 56,000 jobs, the first decline in payrolls in nearly ten years. The Unemployment Rate is expected to have increased to 3.7% from 3.5% in February.